This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

Reconsidering Reverse Mortgages

Times were tough for Dorothy Ariail back in 1977 when she became a young widow with three children. A schoolteacher on a tight budget, she put her children through college using a line of credit on her house in Charleston, S.C. Now she is an 80-year-old semi-retired grandmother with two sons and a daughter who are college-educated professionals—and she’s still using real estate to manage her finances.

Mrs. Ariail owns several houses inherited over the years, and she has taken out a reverse mortgage on one of them. Her loan, a home equity conversion mortgage (HECM), is insured by the federal government and serviced by Generation Mortgage Co., the largest privately owned reverse mortgage retailer and wholesaler in the United States. Guggenheim Partners, a New York-based global financial services firm with more than $125 billion in assets under management, is Generation Mortgage’s controlling shareholder.

“The little house I live in now became available right next to the house I had grown up in, so I decided that it would be nice to be near my children, and the reverse mortgage helped make that all possible,” she says, adding that she rents out her other properties as retirement income while she waits for the housing sales market to improve.

While Dorothy Ariail is happy with her reverse mortgage, the product is often seen as an overpriced retirement income vehicle of last resort for distressed seniors. In fact, advisors typically avoid recommending them to their clients, and following Wells Fargo’s and Bank of America’s exit from the reverse mortgage market in 2011 due to worries about rising defaults, the product has come under an even greater cloud of suspicion.

“It would be a really rare circumstance where a reverse mortgage would fulfill a need for somebody. I’ve never done a reverse mortgage for a client for exactly that reason,” says Susan John, chair of the National Association of Personal Financial Advisors. “There’s always a better alternative.”

Boomers and Big Business

Yet as the U.S. population ages in pricey properties they don’t want to give up, the market for reverse mortgages is growing. In particular, HECMs have gained popularity because the federal government backs the program. As baby boomers age and home prices remain stagnant, seniors are likely to rely on them even more—and ask their financial advisors about reverse mortgages.

Here’s the surprise for advisors who decide to give reverse mortgages a closer look: Under the right circumstances, there are times when the product may actually benefit a client.

“Given that many baby boomers will reach retirement with insufficient wealth from other sources, reverse mortgages are likely to become more popular,” wrote the authors of a Boston College Center for Retirement Research white paper in 2006.

Five years and one Great Recession later, boomers are indeed asking about reverse mortgages. The number of HECMs has skyrocketed since 1989, when the Federal Housing Authority (FHA) started to approve this type of reverse mortgage. According to the National Reverse Mortgage Lenders Association, just 157 HECM loans were made in 1990, the first full year they were available, and the number grew year over year until it reached its peak of 114,692 in 2009. With the continued decline in the housing market, though, the number of loans fell to 79,106 in 2010, the last full fiscal year for which figures are available.

But according to advisors who have already done the research, HECM loans are the most viable reverse mortgages now available, and they are the only ones insured by the FHA. If anything threatens them now, it’s not a lack of demand. It’s the risk that the FHA will go broke and require a tax bailout for the first time in its 77-year history: Acting FHA Commissioner Carol Galante admitted in November 2011 that the FHA is facing “severe economic conditions,” but asserted that the agency’s programs are actuarially sound.

Available only to homeowners over the age of 62 with significant equity, HECMs are a special type of home loan that lets borrowers convert a portion of their home into cash. The property must be the borrower’s primary residence, and the homeowner must have no delinquencies on federal debt. Once those restrictions are met, the advantage of a reverse mortgage is that borrowers can use their equity as cash while they stay in their homes. As the reverse mortgage pays out the equity in a home as cash, the homeowner’s debt level rises and equity decreases, and repayment typically isn’t due until the homeowner sells the property or dies.

Complications and Counseling

To be sure, the product is complicated, borrowers don’t always understand the risks and HECM fees can be steep. Although federal law requires HECM borrowers to receive advice from FHA-funded housing counseling agencies, those services are not always the best. A 2009 report by the U.S. Government Accountability Office found inadequacies in the counseling process, citing instances where counselors failed to discuss other lower cost options available to borrowers and the financial implications of an HECM.

“HUD launched an initiative earlier this year aimed at improving the counseling services,” Morningstar columnist Mark Miller wrote in an August 2011 column. “But more recently, Congress voted to eliminate funding that supported the counseling in a budget-cutting move, raising questions about how the program will be funded starting in October, when the government’s new fiscal year begins.”

Further, the AARP in March 2011 filed a lawsuit against HUD, charging that spouses of deceased HECM borrowers were not sufficiently warned that they were subject to foreclosure if they wanted to stay in the home but could not pay off the balance. In a second suit this year, AARP filed a class action lawsuit against Wells Fargo and Fannie Mae, challenging reverse mortgage foreclosures.

The good news, says Jeffrey Lewis, a senior managing director at Guggenheim Partners and the chairman of the board of Generation Mortgage, is the value proposition presented to consumers in terms of interest rates and how much is available.

“It is as good as it can be because there is no profit margin. It is the triumph of government intervention in a marketplace,” Lewis says.

“The beauty” of the federal reverse mortgage program is that the government is simply trying to make sure that the winners and losers offset each other enough from the FHA’s perspective so the program breaks even, Lewis says, adding that the winners are the homeowners who live a long time while staying in their house.

Like a Home Equity Loan Without the Credit Market Risk

David Heilman, director of business for Franklin Funding, the Charleston-based company that originated Dorothy Ariail’s loan, suggests in an online note promoting Franklin’s services that the tax-free liquidity of a reverse mortgage can create the same advantages of a home equity loan without credit market risk or the uncertainty of housing trends. Heilman suggests a number of ways the product can be used as part of a retiree’s financial plan:

The levels and term of life or long-term care insurance can be increased.

Adult children in the “sandwich generation” can free up resources that had been earmarked for the care of their parents.

Seniors who have lost money in the equity markets can avoid cashing in retirement assets.

Retirement accounts can be left undisturbed while seniors use reverse mortgage proceeds to purchase a vacation home or fund gifts for children or grandchildren.

What’s the smartest choice for borrowers?

“You can put an HECM Saver line of credit in place, not unlike any other home equity line of credit, except with one important difference: you don’t have to pay it back with regular monthly payments,” says Michael Kitces, publisher of “The Kitces Report” and director of research for Pinnacle Advisory Group in Columbia, Md.

Kitces says the HECM Saver charges significantly lower up-front fees by reducing a reverse mortgage’s insurance premium to just 0.01% of the maximum claim amount. That compares to the initial premium of 2% for an HECM Standard reverse mortgage. At the same time, according to Kitces, the lower up-front fees result in less money being made available to the borrower—an outcome that many advisors may find preferable.

‘We May Start Seeing Reverse Mortgages Used by Advisors’

“I’m hearing about a lot of changes going on in that marketplace that I think will make reverse mortgages dramatically more relevant for advisors,” Kitces says. “I don’t think advisors ever were really using them in the first place, but with some of the changes coming forward now, we may start seeing reverse mortgages used for the first time with some increased regularity by advisors.”

Taking the example of a client with a $500,000 house, Kitces says a traditional HECM could allow the borrower about $300,000 against the house’s equity. However, over time, interest on the loan could end up costing more than the value of the house, particularly if housing prices remain sluggish. With the HECM Saver, borrowers can take out a loan of just $100,000 plus interest. When they die, their children can decide whether they want to take $200,000 of their own money to pay off the principal and interest and keep the house, or pay off the loan and distribute the $300,000 that’s left over if they want to sell the house.

“I don’t care how bad the market gets, this loan is virtually never going to be underwater,” Kitces said. “It’s a way to take a loan out against your house and not have cash-flow constraints in paying it back.”

HECM Saver or Standard?

The AARP, despite its lawsuits against HUD, also has given a nod of approval to the HECM Saver, according to financial journalist Jean Chatzky. She quotes AARP spokeswoman Mary Liz Burns as confirming that “the HECM Saver can be a better option for people who want to borrow a smaller amount of money for a short period of time.”

However, Lyn Link, publisher of The Reverse Mortgage Critic website and a former reverse loan broker, counters that if borrowers are interested in using the Saver, they might want to consider the Standard with an adjustable rate, which helps preserve home equity, and then elect the line of credit option and only withdraw what they need when they need it. They would benefit from a lower initial interest rate and a growth rate on the line of credit, he says.

Link is emphatic in stating that a fixed-rate HECM is riskier than an adjustable-rate one. Lenders only allow one option with the fixed rate, the lump sum, while the adjustable rate provides flexibility to structure payments.

“Requiring borrowers to take a lump sum, which could amount to $100,000, $200,000 or more, puts them in jeopardy of spending their money too quickly and could leave them without money for later,” Link writes in an analyst note. “With a lump sum, borrowers are at greater risk of being defrauded out of their money, especially by being sold costly or unnecessary financial products. Because interest and mortgage insurance premium charges will start accruing on the lump sum starting from the day of closing, the compounding effect of these costs will accelerate the depletion of the equity in a borrower’s home much quicker.”

Dorothy Ariail says she was aware of the risks of taking out her HECM Standard reverse mortgage because she discussed them with an HUD counselor, her local banker and a financial advisor. She also discussed the reverse mortgage with the lawyers in her own family. Her son Warren, who runs his own law firm, and her daughter, Bright, who is a partner at Rosen, Rosen & Hagood, both practice in Charleston.

“A reverse mortgage is good if a person needs a bridge, which is what it has been for me. My financial planner wanted me to understand it fully so that I would know exactly how it worked, which I think is good advice,” she says. “Hopefully, if I can keep jumping rope, my children will inherit everything, and then they can go from there. Of course, they’ll have to decide whether to keep this house or what they want to do with it since it’s right next door to our old family home. My son and I have already been talking about how this house could be helpful for him when he retires.”